In 2008, the investment bank Lehman Brothers went bankrupt. The bankruptcy is the biggest in U.S. history, and it played an important role in the global financial crisis. The primary reason that Lehman went bankrupt is explained in the following.




On September 15, 2008, the investment bank Lehman Brothers filed for bankruptcy. The bankruptcy is the biggest in U.S. history; it also played a large role in the global financial crisis. I worked for Lehman during 1994, the year that Lehman became an independent company. Although that was long before the bankruptcy, what I witnessed then was a firm that could not realistically hope to survive. And almost everything that I have seen reported about Lehman since then is consistent with what I witnessed. This essay explains why Lehman was set for bankruptcy from its beginning.

My job at Lehman was to trade options on European government bonds. Lehman had hired me away from another investment bank, Morgan Stanley. Morgan Stanley was the number two investment bank on Wall Street, after Goldman Sachs; Lehman was number four. When I joined Lehman, I had assumed that Lehman would be essentially the same as Morgan Stanley. My assumption was wrong—as illustrated by the following example.

Before I joined Lehman, Lehman's biggest counterparty for options on bonds was an infamous hedge fund, Long-Term Capital Management (LTCM). After I joined, that changed: I was the person responsible for bond options, and I refused to trade with LTCM. My refusal led to consternation at Lehman, and a meeting about it was then held. At the meeting were myself and five other people: the salesman who handled the LTCM account; the head of European bond sales; the head of global bond sales; the head of European bond derivatives (to whom I directly reported); the head of global bond options (to whom I also directly reported).

At the meeting, I explained that Lehman had lost money on every trade previously done with LTCM. Moreover, LTCM was solely wanting to do trades that would lose Lehman money. The five others replied that Lehman had previously done many trades with LTCM, and was now doing none. I again explained that every trade with LTCM had lost money, and further noted that many losses add up to a really big loss. The five others again said that Lehman had previously done many trades with LTCM, and was now doing none. I reiterated. They reiterated. And we continued on like that, repeating the same points.

After over twenty minutes of this, I proposed a compromise. I would do trades with LTCM, but on a condition: that the profit/loss on the trades be kept separate and not be mine; rather, the profit/loss would be theirs. They rejected my condition. I left the meeting.

The meeting was disorienting for me: nothing like that would have happened at Morgan Stanley. There were other things that happened at Lehman that were disorienting as well. In particular, excellent people would sometimes be let go and mediocre people would sometimes be promoted. That applied to traders, salespeople, lawyers, etc.

Occasionally, important events were farcical. An example is described in the book Devil's Casino by Vicky Ward. Ward's book tells how, in 2000, Lehman's CEO, Dick Fuld, decided that Lehman would entirely withdraw from emerging markets. In consequence, all the employees who worked on emerging markets were brought together, told that Lehman was withdrawing, and then fired. A few hours later, Fuld changed his mind, and decided that Lehman would remain in emerging markets after all.

Another farcical event occurred in my own experience. I was doing a trade that required buying many billions worth of bonds (and holding those bonds across a financial quarter end). Such a trade required approval from senior European management; so European management asked me to explain the trade to them. I then tried to explain the trade—but the trade seemed to be beyond their capability to comprehend.

Because European management did not comprehend, they asked global headquarters in New York to decide whether the trade should be approved. Global headquarters, however, misunderstood: they thought that they were being asked to determine whether the trade was legal. For that reason, global headquarters consulted with Lehman's legal department in New York.

The New York legal department did not know whether the trade was legal, because the trade was to be done in England and the department did not have competence at English law. Hence, the New York legal department consulted with Lehman's legal department in London. The London legal department then confirmed that the trade was legal in England. That confirmation was then communicated to the New York legal department, which then passed it on to global headquarters, which then informed European management that the trade should be approved. Thus was the largest trade that Lehman had ever done given authorization.

As the above examples illustrate, the overall quality of skills at Lehman was low. Indeed, the overall quality at Lehman was so low that it sometimes seemed to me that Lehman was merely imitating being an investment bank. Devil's Casino includes a pertinent quote, from a former member of the executive committee at Goldman Sachs: “we never thought [Lehman Brothers] were even in our league … we didn't believe they had superior skill sets”.

Further discussion of Lehman's low quality is in an article published in New York magazine, shortly after Lehman filed for bankruptcy. The article, entitled “Burning down his house”, tells, in particular, that “Everybody in [CEO Fuld's] inner circle had equally undistinguished backgrounds … not top-decile performers”. Relatedly, the Financial Crisis Inquiry Commission, which was appointed by Congress, reported that Lehman's board of directors “had an actress, a theatrical producer, and an admiral, and not one person who understood financial derivatives”. Indeed, the New York article suggests that the people at the top of the firm were inherently mediocre and that they generally preferred to hire other mediocre people to protect their own egos.

The Lehman business model
What had actually been happening at Lehman is the following. Lehman's basic business model was to develop good relationships with clients and to make profits via business dealings that resulted from those relationships. That model would result in losses with a few clients: especially those clients who were savvy and ruthless, such as LTCM. Overall, though, it was a viable business model in the 20th century.

In the 21st century, however, the Lehman business model is not viable. To understand why, consider that with almost any activity, if you have very talented people, equip them with high-tech tools, and train them really well, then they will outperform other people. The size of the outperformance will depend, in part, on how sophisticated the activity is: the more sophisticated the activity, the more important talent, technology, and training are.

In the 20th century, Lehman's main business was based on relatively simple dealings with clients. In the 21st century, as finance became more sophisticated, Lehman could not keep up: in particular, it did not have enough talented people, to equip or to train. Lehman's dearth of talented people was the underlying cause of the various bad business decisions that led to Lehman's bankruptcy.

An analogy can be made with soldiers. I have read that a single squad of modern special-forces soldiers could defeat an entire battalion from World War II. The reasons are similar: select very talented people, give them high-tech equipment, and train them extremely well.

Accounting gimmicks
After Lehman filed for bankruptcy, the courts appointed an examiner (Anton Valukas). The examiner found that Lehman's financial reports were materially misleading. That was due especially to the use of an accounting gimmick (known as “Repo 105”). Use of the accounting gimmick is not legal in the U.S. It is, however, legal in England. Hence, Lehman did the relevant transactions out of a London-based subsidiary.

The accounting gimmick had been used by Lehman, to at least some extent, since 2001. This indicates that Lehman was de facto underperforming long before the global financial crisis.

Many commentators have claimed that Lehman's accounting was good prior to 2001. The claim is misleading, based upon my experience.

As noted above, some of the trades that I did required buying billions worth of bonds. Originally, I had not planned to do those trades, but instead some other trades which were similar. The trades that I had originally planned to do required buying fewer bonds; they also, however, relied upon a trading method known as “synthetic long”. (The method is in some way also a gimmick, but with options it is natural.)

At Lehman, I was told that using the method was not allowed, because it did not comply with accounting principles. I replied that at Morgan Stanley the method had been allowed on the basis of immateriality: i.e. the use of the method did not materially affect the firm's earnings or assets. Lehman's accountants then explained to me that they were already using several other methods on the basis of immateriality, and using an additional method on that basis would result in the firm's overall financial position being materially misrepresented. Thus, Lehman's accounting was operating near the limits of compliance even in 1994.

Conclusion
To conclude, Lehman Brothers was not a viable business for the 21st century, and it was kept afloat until 2008 partially by accounting tricks. The global financial crisis exposed the truth about Lehman's viability; it did not cause Lehman's bankruptcy. In closing, it seems fitting to quote John Stuart Mill: “Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works”.



Douglas J. Keenan